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Playing Defense on Bonds

The recent bull market in bond prices has been called the biggest bond bubble in history. Thanks to a combination of stock-averse investors and multi-billion dollar purchases of U.S. Treasuries by the Federal Reserve, higher bond prices have fueled the boom. But what happens when the trend reverses? How can advisors shield clients from the bond market’s eventual fall?

All bonds have three main risks: credit, currency and interest rate risk. And to some extent, bond ETFs can help to reduce these risks, particularly in diversifying away from single bond issues. However, even with broadly diversified bond funds, rising rates can severely damage bond values.

How can advisors estimate the potential damage of rising interest rates on a bond portfolio? Eric Jacobson, a fixed income analyst at Morningstar, says to focus on bond durations.

To estimate the level of interest rate sensitivity on a bond portfolio, Jacobson uses a simple formula that multiplies a bond’s duration by 1%. For instance, if interest rates were to rise by 1%, it would mean bonds with duration of 2.5 years should lose around 2.5% in value.

Jacobson warns that his formula for estimating bond losses is just a mathematical construct and doesn’t necessarily account for changes in interest rates in every scenario. While the formula can sometimes be thrown off because shorter-term interest rates move up while longer-term rates move down—or other oddities—he says the formula is still a good barometer of what an investor can expect in a scenario of interest rate spikes.

Looking Abroad

Europe’s sovereign debt crisis has highlighted the danger of concentrated credit risk. Rather than investing in government debt from just one country, some advisors are opting for diversified bond exposure to multiple countries, including emerging markets (EMs).

Local-currency EM bond ETFs also offer another opportunity to diversify credit risk along with currency risk. These types of funds invest in emerging market sovereign debt that is publicly issued and denominated in the issuer’s own domestic market and currency. This feature adds a level of currency diversification, away from the U.S. dollar.

For advisors concerned about the threat of inflation, the iShares Global Inflation Linked Bond ETF (GTIP) could be a good choice. Rather than using a U.S. TIPS-focused fund, which exposes the investor to credit risk concentrated on the U.S. government, GTIP owns TIPS from a basket of various countries, including Canada, France and the United Kingdom. Diversifying credit risk with an ETF like GTIP is easily accomplished.

Strategic Trades

Another way for hedging against falling bond prices is to trade into short or inverse bond ETFs. These funds are mainly designed as short-term strategic trades, not long-term investment bets.

Aggressive bond bear ETFs include the Direxion Daily 20+ Year Treasury Bond ETF 3x (TMV) and the ProShares UltraShort 20+ Yr Treasury Bond 2x ETF (TBT). Both ETFs aim for daily opposite performance with 300% and 200% leverage. The level of daily leverage chosen should be in line with the maximum amount of aggressiveness that an advisor wants.

Non-leveraged inverse bond ETFs offer another way to capture gains in a bond market with declining values. The Direxion Daily Total Bond Market Bear 1x (SAGG) and Direxion Daily 20+ Yr Treasury Bond ETF 1x (TYBS) use 100% daily opposite performance to both the U.S. bond market and long-term U.S. Treasuries. Both ETFs also offer a more conservative way to play the theme of falling bond prices compared to their leveraged cousins.

Buying Insurance

“While I am not a present fan of fixed income, I do feel many bond buyers are taking risks for which they might be ill prepared,” argues Joseph G. Witthohn, CFA and vice president of product development and ETF strategies at Emerald Asset Management in Leola, Pa. One way to guard against those risks is by using defensive put options.

Unlike bond mutual fund investors, owners of bond ETFs have the flexibility of insuring their bond positions. Buying protective insurance via put options on bond ETFs is another strategy for limiting the impact of falling bond prices. Put options are designed to increase in value when the underlying asset or ETF falls in price. In other words, any losses in the value of bond ETFs would be offset by gains in the underlying put options.

“Put options move in a nonlinear fashion, which enables a small dollar amount of them to hedge a much larger dollar value position in an underlying security,” says Dave Pinsen, with Portfolio Armor. His company has developed an algorithm program to find optimal puts options that give the level of protection an investor wants at the lowest possible cost.

Many of the top fixed income ETFs like the iShares Core Total U.S. Bond Market ETF (AGG) and iShares iBoxx $ Invest Grade Corp Bond (LQD) have underlying put options trading on them. The length of insurance coverage via put options can be as short as one month or up to a year, depending on when the options contracts expire. In other words, advisors can customize the length of insurance with options to match their client’s unique needs.

Playing Defense

No one can accurately predict when the current cycle of high bond values and low yields will unravel. “The only viable strategy today in fixed income is to be very short and leg out maturities as rates rise. There is no holy grail and no manager of genius that can change the fact that rates are where they are,” concludes Morgan.

And while market cycles—such as the low rate environment we’re in—can often last longer than anyone expects, they never last indefinitely. That means advisors should be preparing client portfolios for the next big trends in the bond market. Playing offense has been great, but now it may be the time to start playing some defense.